I
think it was almost two years ago that I was in Cyprus. Cyprus had just come
through its crisis and was still in shell shock. I was there to get a feel for
what it was like, and a number of my readers had courteously arranged for me to
meet with all sorts of people and do a few presentations. A local group
arranged for me to speak at the lecture hall of the Central Bank of Cyprus in
Nicosia.

There
were about 50 people in the room. I was busily working on Code Red at the time and had
money flows, quantitative easing, and currency wars at the front of my brain.
As part of my presentation, I talked about how countries would seek to use
currency devaluation in order to gain an advantage over other countries – that
we were getting ready to enter an era of currency wars, which would be
disguised as monetary policy trying to create economic growth. Which is exactly
what we have today. Every now and then I get a few things right.

After
my short presentation, during the question and answer period, I pointed to a
distinguished-looking gentleman to ask the fourth question. Before he could get
his question out, my host stood up and said, “John, I just want to give you
fair warning. This is Christopher Pissarides. He recently won the Nobel Prize in
economics and is a professor at the London School of Economics, as well as
being a Cypriot citizen.”

Professor
Pissarides preceded his question by citing a great deal of literature, some of
it his own, which showed that a country could not gain a true advantage by engaging
in currency manipulation. “So why do you think there would be currency wars?
What would it gain anybody?” he asked.

We
proceeded to have a conversation that basically boiled down to the old Yogi
Berra maxim: In theory, theory
and practice are the same thing. In practice they differ.

Dr.
Pissarides was of course absolutely right. Beggar-thy-neighbor policies end up
making everybody worse off at the end of the day. However, there is a
short-term first-mover advantage. In a short-term world, people do things to
show they are being “proactive.” And in a world of “every central banker for
himself,” where central banks are essentially trying to position their
countries to prosper, you wind up having multiple iterations of tit for tat.

And
that is just one of the points that our old friend Lacy Hunt of Hoisington
Management makes in this week’s Outside
the Box:

In our review of historical and present cases of
over-indebtedness, we noticed some overlapping tendencies with less regularity
that are important to mention.

First, when all major economies face severe debt
overhangs, no one country is able to serve as the world’s engine of growth.
This condition is just as much present today as it was in the 1920-30s.

Second, currency depreciations result as
countries try to boost economic growth at the expense of others. Countries are
forced to do this because monetary policy is ineffectual.

Third, devaluations do provide a lift to
economic activity, but the benefit is only transitory because other countries
that are on the losing end of the initial action retaliate. In the end every
party is in worse condition, and the process destabilizes global markets.

Fourth, historically advanced economies have
only cured over-indebtedness by a significant multi-year rise in the saving
rate or austerity. Historically, austerity arose from one of the following:
self-imposition, external demands or fortuitous circumstances.

I’m
increasingly convinced that central banks have distorted the entire
macroeconomic landscape to such an extent that we have entered uncharted
waters. That will be the theme of my letter this upcoming weekend, but Lacy’s
quarterly serves as a good introduction.

The
weather has turned exceedingly nice in Dallas, Texas. The trees have filled
out, the flowers are blooming, and we have had enough rain (thank goodness) to
make everything green.

I
pretty much enjoy all sports, and Dallas is generally blessed with having one
or two of our teams actually play well in any given year. I think I like
professional basketball the most. At the professional level it is the most
beautiful of all sports. For a brief time in their life, these young gods of
the court can do things that mere mortals can never experience. But it is such
a joy to watch. I’ve had season tickets for 32 years, and in the last few years
have finally have been able to work my way down from the very top-corner row to
where my seats are now “most excellent.”

Tonight
is the unofficial beginning of the NBA playoffs for the Western Conference. I
say “unofficial” because, technically, the playoffs start this weekend; but
only two teams in the West actually know their seed positions.

Dallas is locked
in at number seven, but there are still four mathematical possibilities for the
number-two seed to face us. It all comes down to who wins and loses tonight.
This is the closest basketball race that I can remember. Two or three teams
vying for a playoff spot, sure, that’s common. But there are seven or eight
teams in the conference this year that could get hot during the playoffs and
make it to the top. The Mavericks have the deepest bench of any team in the
NBA, but there are a lot of new players who have been added recently, and it
sometimes feels like you want to introduce them to each other. We could be one
and done or go all the way. It’s just really hard to figure this team out from
night to night. But that’s what makes it fun.

Have
a great week, and I wherever you are, I hope your weather is treating you well,
too. I guess we should be grateful that a group of 12 people don’t get to sit
around a big conference table and vote on what the weather should be like and
then try to adjust it. Actually, that’s a good analogy. Think about it.

You’re
hoping to be watching playoffs in late May analyst,

John Mauldin, Editor
Outside the Box

Hoisington Quarterly Review and Outlook – First Quarter 2015

Characteristics
of Extremely Over-Indebted

Economies

Over the more than two thousand years of
economic history, a clear record emerges regarding the relationship between the
level of indebtedness of a nation and its resultant pace of economic activity.
The once flourishing and powerful Mesopotamian, Roman and Bourbon dynasties, as
well as the British empire, ultimately lost their great economic vigor due to
the inability to prosper under crushing debt levels. In his famous paper “Of
Public Finance” (1752) David Hume, the man some consider to have been the
intellectual leader of the Enlightenment, wrote about the debt problems of
Mesopotamia and Rome. The contemporary scholar Niall Ferguson of Harvard
University also described the over-indebted conditions in all four countries
mentioned above. Through the centuries there are also numerous cases of less
prominent countries that suffered a similar fate of economic decline resulting
from too much debt as a percent of total output.

The United States has experienced four bouts of
great indebtedness: the 1830-40s, the 1860- 70s, the 1920-30s and the past two
decades. Japan has been suffering the consequences of a massive debt over-hang
for the past three decades. In its first of three thorough studies of debt, the
McKinsey Global Institute (MGI) identified 32 cases of extreme indebtedness
from 1920 to 2010. Of this group, 24 were advanced economies of their day.

The countries identified in the study, as well
as those previously cited, exhibited many idiosyncratic differences. Some were
monarchies or various forms of dictatorships. Others were democracies, both
nascent and mature.

Some countries were on the Gold Standard, while others had
paper money.

Some had central banks and some did not. In spite of these
technical and structural differentiations, the effect of high debt levels
produced the clear result of diminished economic growth. Indeed, the fact that
the debt impact shows through in these diverse circumstances is a clear
indication of the powerful deleterious impact of too much debt. Six
characteristics seem to be uniform in all circumstances of over-indebtedness in
historical studies, and these factors are evident in contemporary times in the
U.S., Japanese and European economies.

Six
Characteristics

Transitory upturns in economic
growth, inflation and high-grade bond yields cannot be sustained because
debt is too much of a constraint on economic activity.

Due to inherently weak
aggregate demand, economies are subject to structural downturns without
the typical cyclical pressures such as rising interest rates, inflation
and exhaustion of pent-up demand.

Deterioration in productivity
is not inflationary but just another symptom of the controlling debt
influence.

Monetary policy is ineffectual,
if not a net negative.

Inflation falls dramatically,
increasing the risk of deflation.

Treasury bond yields fall to
extremely low levels.

The
Non-Sustainability of Transitory Gains

Nominal GDP is the most reliable of all the
economic indicators since, as the sum of cash register receipts, it constitutes
the top line revenues of the economy. From this stream, everything must be
paid. Current nominal GDP growth shows the economy’s inability to sustain
progress in growth (Chart 1).

The change over the four quarters ending December
31, 2014 was only 3.7%, which is barely above the average entry point for all
recessions since 1948.

Nominal GDP can be sub-divided into two parts.
First is the implicit price deflator, which measures price changes in the
economy, and the second is real GDP, which is the change in the volume of
goods. Both of these components are volatile, but the recent data shows a lack
of strong momentum in economic activity. The year-over-year change in the
deflator has accelerated briefly in this expansion, but the peak remained below
the cyclical highs of all the expansions in every decade since the 1930s (Chart
2).

In the past fifteen years, real per capita GDP
(nominal GDP divided by the price deflator and population) grew a paltry 1% per
annum. This subdued growth rate should be compared to the average expansion of
2.5%, which has been recorded since 1940. The reason for the remarkably slow
expansion over the past decade and a half has to do with the accumulation of
too much debt.

Numerous studies indicate that when total indebtedness in the
economy reaches certain critical levels there is a deleterious impact on real
per capita growth. Those important over-indebtedness levels (roughly 275% of
GDP) were crossed in the late 1990s, which is the root cause for the
underperformance of the economy in this latest expansion.

It is interesting to note that in this period of
slower growth and lower inflation, long-term Treasury bond yields did rise for
short periods as inflationary psychology shifted higher. However, the slow
growth meant that the economy was too weak to withstand higher interest rates,
and the result was a shift to lower rate levels as the economy slowed. Since
the U.S. economy entered the excessive debt range, eight episodes have occurred
in which this yield gained 84 basis points or more (Chart 3). Nevertheless,
none of these rate surges presaged the start of an enduring cyclical rise in
interest rates.

Downturns
Without Cyclical Pressures

Many assume that economies can only contract in
response to cyclical pressures like rising interest rates and inflation, fiscal
restraint, over-accumulation of inventories, or the stock of consumer and
corporate capital goods. This idea is valid when debt levels are normal but
becomes problematic when debt is excessively high.

Large parts of Europe contracted last year for
the third time in the past four years as interest rates and inflation
plummeted. The Japanese economy has turned down numerous times over the past
twenty years while interest rates were low. Indeed, this has happened so often
that nominal GDP in Japan is currently unchanged for the past twenty-three
years. This is confirmation that after a prolonged period of taking on excessive
debt additional debt becomes counterproductive.

Faltering
Productivity is Not Inflationary

Falling productivity does not cause faster
inflation. The weaker output per hour is a consequence of the over-indebtedness
as much as the other five characteristics mentioned above. Productivity is a
complex variable impacted by many cyclical and structural influences.
Productivity declines during recessions and declines sharply in deep ones.
Nonfarm business productivity has grown at an average rate of 2.2% per annum
since the series originated in 1952 (Chart 4). As a general rule the growth
rate was above the average during economic expansions and lower than the
average in recessions.

Over the past four years, nonfarm productivity
growth has slumped to its lowest levels since 1952, with the exception of the
severe recession of 1981- 82. Such a pattern is abnormally weak. Interestingly,
the Consumer Price Index was unchanged in the past twelve-month period (Chart
5). In an economy purely dominated by cyclical forces, as opposed to one that
is highly leveraged, both productivity and inflation would not be depressed.

Monetary Policy
Is Ineffectual

Monetary policy impacts the overall economy in
two areas – price effects and quantity effects. Price effects, or changes in
short-term interest rates, are no longer available because rates are near the
zero bound. This is a result of repeated quantitative easing by central banks.
It is an attempt to lift overly indebted economies by encouraging more
borrowing via low interest rates, thus causing even greater indebtedness.

Quantity effects also don’t work when debt
levels are excessive. In a non-debt constrained economy, central banks have the
capacity, with lags, to exercise control over money and velocity. However, when
the debt overhang is excessive, they lose control over both money and velocity.
Central banks can expand the monetary base, but this has little or no impact on
money growth. Further, central banks cannot control the velocity of money,
which declines when there is too much unproductive debt. This happened in
the1920s and again after 1997 and is continuing to decline today (Chart 6).

Monetary policy can be used to devalue a
country’s currency, but this benefit is short-lived, and to the extent that it
works, conditions in other countries are destabilized causing efforts at
currency devaluation to invoke retaliation from trading partners.

Inflation Falls
So Much That Deflation Risk Rises

Extremely high levels of public and private debt
relative to GDP greatly increase the risk of deflation. Deflation, in turn,
serves to destabilize an economy that is over-indebted since the borrowers have
to pay back loans in harder dollars, which transfers income and wealth from
borrowers and creditors.

Such a deflation risk is present in the United
States and other important economies of the world. During and after the mild
recessions of 1990-91 and 2000-01, the rate of inflation in Europe and the United
States fell by an average of 2.5%. With inflation near zero in both economies
today, even a mild recession would put both in deflation.

Real Treasury
Bond Yields

In periods of extreme over-indebtedness Treasury
bond yields can fall to exceptionally low levels and remain there for extended
periods. This pattern is consistent with the Fisher equation that states the
nominal risk-free bond yield equals the real yield plus expected inflation
(i=r+E*). Expected inflation may be slow to adjust to reality, but the
historical record indicates that the adjustment inevitably occurs.

The Fisher equation can be rearranged
algebraically so that the real yield is equal to the nominal yield minus
expected inflation (r=i–E*). Understanding this is critical in determining how
unleveraged investors fare. Suppose that this process ultimately reduces the
bond yield to 1.5% and expected inflation falls to -1%. In this situation the
real yield would be 2.5%. The investor would receive the 1.5% coupon but the
coupon income would be supplemented since the dollars received will have a
greater purchasing power. A 1.5% nominal yield with real income lift might turn
out to be an excellent return in a deflationary environment. Contrarily,
earnings growth is problematic in deflation. Businesses must cut expenses
faster than the prices of goods or services fall. Firms do not have experience
with such an environment because deflation episodes are infrequent. If this
earnings squeeze eventuated, then a 1.5% nominal bond yield and 2.5% real yield
might be very attractive versus equity returns.

Global Concerns

In our review of historical and present cases of
over-indebtedness, we noticed some overlapping tendencies with less regularity
that are important to mention.

First, when all major economies face severe debt
overhangs, no one country is able to serve as the world’s engine of growth.
This condition is just as much present today as it was in the 1920-30s.

Second, currency depreciations result as
countries try to boost economic growth at the expense of others. Countries are
forced to do this because monetary policy is ineffectual.

Third, devaluations do provide a lift to
economic activity, but the benefit is only transitory because other countries
that are on the losing end of the initial action retaliate. In the end every
party is in worse condition, and the process destabilizes global markets.

Fourth, historically advanced economies have
only cured over-indebtedness by a significant multi-year rise in the saving
rate or austerity. Historically, austerity arose from one of the following:
self-imposition, external demands or fortuitous circumstances.

Overview of
Present Conditions

Our expectations for the economy in 2015 are
that nominal GDP should grow no more than 3% this year. M2 appears to be
expanding around a 6% rate, and velocity is falling at a trend rate of 3%. The
risk is that velocity will be even weaker this year; thus, 3% nominal GDP
growth may be too optimistic. The ratio of public and private debt to GDP rose
last year and economic growth softened. The budget deficit was lower in 2014
than 2013, but gross government debt rose again last year and a further
increase is likely in 2015. This is not a positive signpost for velocity. The
slower pace in nominal GDP in 2015 would continue the pattern of the past two
years when nominal GDP decelerated from 4.6% in 2013 to 3.7% in 2014 on a
fourth quarter to fourth quarter basis. Such slow top line growth suggests that
both real growth and inflation should be slower than last year.

Many factors can cause intermittent increases in
Treasury yields, but economic and inflation fundamentals are too weak for
yields to remain elevated.

Therefore, the environment for holding long-term
Treasury bond positions should be most favorable in 2015.

WHEN “60 Minutes”, an American television news programme, visited a new district in the metropolis of Zhengzhou in 2013, it made it the poster-child for China’s property bubble. “We found what they call a ghost city,” said Lesley Stahl, the host. “Uninhabited for miles and miles and miles and miles.” Two years on, she would not be able to say the same. The empty streets where she stood have a steady stream of cars. Workers saunter out of offices at lunchtime. Laundry hangs in the windows of the subdivisions.The new district (pictured), on the eastern side of Zhengzhou, a city of 9m in central China, took off when the provincial and city governments relocated many of their offices there. Then, high schools with university-sized campuses began admitting students, drawing families to the area. Last autumn one of the world’s biggest children’s hospitals opened, a gleaming facility with cheery colours and 1,100 beds. Chen Jinbo, one of the area’s earlier residents, bemoans the lost quiet of a few years ago. “Rush hour is a hassle now.”The success of Zhengzhou’s development belies some of the worst fears about China’s overinvestment. What appear to be ghost cities can, with the right catalysts and a bit of time, acquire flesh and bones. Yet it also marks a turning-point for the Chinese economy. Zhengzhou still has ambitious plans, not least for a massive logistics hub around its airport. With such a big urban area already built up, though, vast construction projects have a progressively smaller impact on the economy. The city’s GDP growth fell to 9.3% last year from an average of more than 13% over the preceding decade. The downward trend will continue. As the capital of Henan, one of the country’s poorest provinces, Zhengzhou had anchored the country’s last, large, fast-growth frontier. Its maturation signals that the slowing of China’s economy is not a cyclical blip but a structural downshift.When growth flagged in powerful coastal provinces a few years ago, the poorer interior picked up the slack. It was large enough to do so, for a time. Henan and the other inland provinces that have a similar level of income per head have 430m residents, nearly a third of China’s total. If they were a sovereign country, they would form the world’s seventh-biggest economy, ahead of both Brazil and India. The far west is China’s final underdeveloped region but it carries much less weight: it makes up less than a tenth of the national population.So the question for China is not whether growth will rebound to anything like the double-digit pace of the past. Instead, it is whether its slowdown will be a gradual descent—a little bumpy at times but free from crisis—or a sudden, dangerous lurch lower. Figures released on April 15th revealed a further loss of altitude: GDP in the first quarter grew by 7% from a year earlier, the lowest since the depths of the global financial crisis in early 2009. Signs of stress are emerging: capital is leaving the country, public finances are more stretched and bad debts are rising.Yet that is not the full story. China also has impressive underlying strengths and a new determination to fix its most harmful distortions. “Growth will keep on declining,” says Xiang Songzuo, chief economist with Agricultural Bank of China, a state-owned lender. “Our main wish is that the decline go smoothly.”

Storm warning

The darkest cloud over China is its property market. Factoring in its impact from steel to furniture, it has powered nearly a fifth of the economy. Now, it is set to subtract from growth. House prices have fallen by 6% over the past year, the steepest drop since records began. It is not the first time that the property market has looked fragile, but previous dips were driven by deliberate policies to cool the market. In recent months, it has been the opposite: demand has failed to respond to a series of boosts such as cheaper mortgage rates. This has prompted predictions of a coming crash.Problems are real but such disaster warnings rest on a misdiagnosis. The oft-heard idea that China is sitting on mountains of unsold homes is an exaggeration. Those making this claim point to the gap between property sales and construction. Sales of residential housing last year were 20% higher than they were in 2009, but projects under way have more than doubled since then, according to official data. If true, it would take five years to consume the pipeline of homes being built, up from three before the global financial crisis.But many of those projects are in fact little more than holes in the ground. Some have been halted for a lack of funds, others because developers want to wait to sell into a stronger market. The evidence for this is actual construction activity, indicated by property completions as well as cement production (see chart 1). These are a much closer fit with sales. It will take 16 months to clear China’s inventory of new homes at the current sales rate, up from ten months when the market was in better shape, according to E-House, a property consultancy. This points to a deterioration but hardly a nightmare.

That China’s property market is not about to collapse under the weight of oversupply is good. The bad news is that its growth is stalling. The housing sector started to take off early this century after the government allowed ownership of private property. Mass migration to cities added to demand; China’s urbanisation rate has more than doubled to 55% today from 26% in 1990. Both these factors are fading. Many Chinese have already upgraded to snazzier flats than their original state-issued boxes. And the pace of urbanisation is slowing.Many analysts now expect housing sales, which have reached about 10m units annually, to start falling soon. There will still be homes aplenty to build but fewer with each passing year. Those who were over-optimistic about the longevity of the boom are paying a price. Chinese steelmakers had created capacity for 1.2 billion tonnes a year. The 820m tonnes produced last year may well be the top.Property is thus turning from a driver into a drag for the Chinese economy. Wang Tao of UBS, a bank, estimates that every ten percentage-point drop in construction growth cuts as much as three percentage points off GDP. She forecasts a deceleration of about half that pace this year.The more sedate reality is sinking in. In the south of Henan province, the county of Gushi had wanted to expand its central city to reach a population of 1.2m, from 500,000 now. Construction work is feverish. The clang of hammers and the growl of diggers reverberate throughout its streets. But with housing sales failing to meet expectations, Gushi has lowered its sights. It is aiming instead for a population of 800,000. Muddy fields on the outskirts that had been zoned for development seem destined to remain untouched.

Dragged down by debt

One way China could rekindle its property market is by using its banks to pump cash into the economy, as it did in 2008 when the global financial crisis struck. Yet that would be a dreadful mistake. Officials have their hands full already trying to deal with the legacy of the previous lending binge. Total debt has surged, rising from about 150% of GDP in 2008 to more than 250% today (see chart 2). Increases of smaller magnitudes were precursors to financial turmoil in Japan in the 1990s and much of the West over the past decade.

With debt clogging up the economy’s gears, Chinese lending has grown less potent. In the six years before the financial crisis, each yuan of new credit resulted in about five yuan of economic output. In the six years since the crisis, each yuan of credit has yielded three of output. Banks report that a mere 1.25% of their assets have soured, but investors price their shares as if the true number is closer to 10%. Within banks themselves, there is distrust. “The headquarters don’t believe the provinces,” says a credit officer with a major lender.Until recently China could grow its way out of debt trouble. That is no longer an option. With deflation arriving and the economy weakening, nominal growth is a third as fast as a few years earlier. In the year to the first quarter of 2015, nominal GDP grew by only 5.8%. The financial system is also far more complex than it was in the late 1990s, the last time China had a surge in bad debts. State-owned banks accounted for almost all lending back then. Since the financial crisis their share has fallen to less than two-thirds. Loosely regulated “shadow banks” make up much of the rest.But there is no ironclad law that a big rise in debt must result in crisis. Much depends on how liabilities are managed. China has several advantages. The vast majority of its debts are held at home. In many cases both debtors and creditors answer to the same master, the government. A state-owned bank is not about to call in a loan from a state-owned shipbuilder. This buys it time to sort out the mess. Debts are also concentrated. Households have not borrowed much, nor has the central government. The main culprits are local governments and a relatively narrow group of companies: state-owned enterprises, property developers and construction firms.China’s defences are now being tested by the prospect of the first big default in its property sector. Kaisa, a developer embroiled in a corruption case, is in negotiations with bondholders to restructure its debt. So far there has been no contagion throughout the financial industry. Investors have come to the same conclusion as Moody’s, a ratings agency: it is an isolated case, not symptomatic of systemic risks.In that respect, China’s debt problem is similar to its property malaise. An acute crisis is unlikely, but the prognosis is still bleak. Credit growth has fallen below 15% year-on-year, down by more than a quarter from the average of the past decade. But since nominal growth is even slower, China’s debt-to-GDP level continues to rise. Lending will thus have to slow yet further, one more dark cloud over the horizon.

Back-up power

Reporting about China’s economy sometimes gives the impression that it is one giant credit-fuelled property bubble. Were that true, the twin slowdowns in construction and lending would be enough to wrestle growth down to the low single digits, perhaps even into recession—a scenario touted for years by the most bearish analysts. China’s downturn still has a way to run but such pessimism has consistently been wide of the mark. A simple, if under-appreciated, reason is that it is a continent-sized economy, with a lot more going for it than one or two industries. And although the days of explosive catch-up growth are over now that China has gained middle-income status, it has scope for more moderate catch-up. Its per-capita GDP at purchasing-power parity is $12,000, not quite two-thirds that of Turkey and barely a third of South Korea’s.A much-needed shift towards consumption-led growth is just getting under way. Investment accounts for 50% of economic output, well beyond what even Japan and South Korea registered in their most intensive growth phases. Without rebalancing, overcapacity in industry would only get more severe, further undermining the return on capital. At last, there are glimmers of hope. Investment growth has halved in recent years but consumption growth has held steady; in future, as China’s growth slows, consumption should contribute a bigger share of it (see chart 3).

This is in part testament to the government’s progress in constructing a social safety net. Health insurance, old-age benefits and free schooling, though works in progress, appear to have helped check the remarkable propensity of Chinese to save. At 40% of income, the household savings rate has stopped rising in recent years.Still more important is a change in economic structure. Services took over from industry a couple of years ago as the biggest part of China’s economy, and the gap has widened. Last year services accounted for 48.2% of output; industry’s share was down to 42.6%. Services are more labour-intensive, which brings two benefits. First, China is now able to generate many more jobs at lower levels of growth. Though growth dipped to its slowest in more than two decades last year, China created 13.2m new urban jobs, an all-time high. Second, the strong jobs market has allowed wages to keep on rising at a steady clip, a prerequisite for getting people to consume more.Even in Gushi, a county officially classified as impoverished, people throng to clothing stores, beauty parlours and the town’s one foreign restaurant (a KFC). Like many there, Zhang Youling, 43, spent much of his adult life away, going to where the jobs were. He worked as a builder in Beijing, a courier in Shanghai and an ice-cream wholesaler in Zhengzhou before returning to Gushi to be with his wife and two children. For the coming summer, he has set aside 6,000 yuan ($970) to take them to Beijing on holiday. “We used to save everything. These days we have the confidence to spend some of what we earn,” he says.

Changing course

It would be complacent to expect that rebalancing alone will spare China from trouble. Surging debt and property overinvestment stem from flaws in the economy’s foundations. Regulations constrain investment options, making property one of the few viable assets; this drives up house prices. Local governments have limited tax powers, and so rely on land sales; this leads to more property development. The belief that the central government will always prop up cities induces banks to lend with little regard for creditworthiness; this heaps bad debt onto the economy.These interlinked problems were easily ignored while growth surged ahead. Now the government can avoid them no longer. It is trying three kinds of reform.The first is financial liberalisation. Monetary policy is virtually unrecognisable from five years earlier, when the central bank controlled all key interest rates. Funding costs throughout the economy are now more market-based. Banks compete for deposits with an array of investment products; households place 30% of their savings in bank-account substitutes, up from 5% in 2009. Official deposit rates are still fixed, but regulators have given banks flexibility (currently, a 2.5-3.25% range) and hint at full liberalisation within a year.The government has also relaxed capital controls. Companies previously needed approval for overseas investments above $100m; late last year the threshold was raised to $1 billion. In recent months, capital outflows have surged. Some say this is because Chinese are losing faith in their country. Regulators are far more sanguine, pointing to it as a sign of a better-balanced economy. The alternative—trapping money in China at artificially low interest rates and encouraging wasteful investment—was bound to be more destructive.

Jam today in Zhengzhou

The second area for reform is fiscal, a push that has just begun. The problem is that municipalities have too many spending obligations and not enough revenue. The central government will provide more funding and give local governments new taxation powers. Under a revised budget law, all provinces are, for the first time, allowed to issue bonds, albeit subject to central approval. The finance ministry has also started to mop up their debts; it plans to restructure 1 trillion yuan of liabilities.Bureaucratic reforms are the third focus. Here, progress has been uneven. Changes to the household-registration system, or hukou, to allow rural citizens to settle in big cities have been halting. More is needed to make for a healthier labour market. China has also disappointed those hoping for bold reforms of sluggish state-owned enterprises, but smaller shifts may help. By injecting assets from unlisted state parents into listed subsidiaries, groups such as Citic will face closer market scrutiny. At the same time, the government is loosening its grip on other important levers. It has simplified the process for registering new companies. Entrepreneurs can now, for instance, use non-cash assets as capital. They created some 3.6m firms last year, up by nearly 50% from 2013.Reforms are themselves generating new risks. A bull run in the stockmarket over the past six months is beginning to resemble the asset bubbles that often arise when countries plunge into financial liberalisation. But keeping the previous economic system in place would be more dangerous. It would make growth faster in the short term but at the cost of ever more debt, heightening the risk of an eventual crash. Taken together, the policy shifts should smooth China’s transition to slower but more resilient growth.The transition will take time. For now, investment still accounts for half the economy. In Zhengzhou, a layer of construction dust covers much of the city’s southern half. Along with building a vast new airport terminal, workers are digging tunnels for five new subway lines. Traffic is snarled for hours in the evening as trucks haul pillars into place for elevated highways. The pressing concern for residents stuck in the congestion is not economic collapse but rather the continued headaches of growth, even if it is a little weaker than last year.

Far from declining, family firms will remain an important feature of global capitalism for the foreseeable future, argues Adrian Wooldridge

Apr 18th 2015

FAMILIES HAVE ALWAYS been at the heart of business. Family companies are among the world’s oldest. The Hoshi Ryokan, an inn in Japan, has been in the same family since 718. Kongo Gumi, a Japanese family construction firm, was founded even earlier, in 578, but went bust in 2006. The Antinori family has been producing wine in Tuscany since 1385 and the Berettas have been making guns since 1526. Family companies played a starring role in the development of capitalism: think of the Barings or the Rothschilds in banking or the Fords and Benzes in carmaking. Family companies are ideally suited to the early stages of capitalism. They provided two of the most important ingredients of growth, trust and loyalty, in a world where banking and legal institutions were often rudimentary and poor communications made far-flung activities hard to control. It was easier to raise money from kinsmen than from strangers. And it was safer to send a relative than a hired hand to expand the business abroad.Business enterprises also provided patriarchs with a way of transmitting wealth and status to future generations. “The banker’s calling is hereditary,” said Walter Bagehot, a distinguished 19th-century editor of this newspaper. “The credit of the bank descends from father to son; this inherited wealth brings inherited refinement.” Family dynamics sometimes dictated business strategies: the Rothschild bank helped to globalise finance when Mayer Amschel Rothschild, the dynasty’s founder, sent his five sons to set up banks in different countries.Serious thinkers have given surprisingly little thought to the family dynamics behind the early stages of capitalism. Novelists are a better guide to this subject than classical economists. In “Dombey and Son” Charles Dickens describes how Dombey wants to pass his business on to his son but is frustrated by a scheming manager. Thomas Mann’s “Buddenbrooks” is about the children of a great business founder turning their backs on the bourgeois virtues that built the family’s fortunes.Business gurus have also given family firms short shrift. Alfred Chandler, the doyen of business historians, regarded family companies as relics of an earlier era that found it hard to muster the capital and talent needed to compete. The real engines of modern capitalism were public companies, owned by diverse shareholders and run by professional managers. Peter Drucker, the doyen of management theorists, reckoned that the drivers of these great engines were professional “knowledge workers”, not business patriarchs and their families.Chandler was right that public companies made enormous advances in the late 19th and early 20th centuries as capital-intensive businesses turned to public markets for funds. But he was wrong in his prediction that they would push family companies to the margins of the modern economy. Even in the Anglo-Saxon world, where public companies gained the most ground, families held on to some of the most prominent businesses, such as Walmart, the world’s largest retailer, and Ford, one of the largest car companies. In continental Europe public companies remained the exception.Thirty-eight years after Chandler published his paean of praise for the public company, “The Visible Hand”, family companies still provide many of the necessities of life. You can get your news from the New York Times and the Wall Street Journal; your car from Ford or Fiat; your smartphone from Samsung or LG; and your groceries from Walmart or Aldi. In a scholarly book, “Dynasties”, the late David Landes of Harvard University demonstrated that you could write a respectable history of capitalism through the lens of family histories. You could write an equally respectable survey of the state of modern capitalism by telling the story of a dozen family firms.Family businesses make up more than 90% of the world’s companies. Many of them are small corner shops. This special report will focus on the larger companies that shape the global economy and develop world-changing products and ideas. The point is to show that family businesses can flourish in the most sophisticated areas of the modern economy.Defining these larger family companies is tricky. If you restrict the term to companies that are both owned and managed by family members, you will end up with remarkably few. If you expand it to include companies that are run by the founders, you will take in tech giants such as Google and Facebook, which few people would see as family firms. The Boston Consulting Group has produced a reasonable definition made up of two elements: a family must own a significant share of the company concerned and be able to influence important decisions, particularly the choice of chairman or CEO; and there must have either been a transition from one generation to the next, or, in the case of a founder-owned firm, plans for such a transition. On that definition, BCG calculates, family companies represent 33% of American companies and 40% of French and German companies with revenues of more than $1 billion a year. In Asia and Brazil they are even more prevalent (see chart 1)..

Powerful families are also adept at using pyramid-style business holdings to keep a controlling number of shares in other companies. Randall Morck, of the University of Alberta, points out that the Wallenberg family controls companies that represent up to half the market capitalisation of the Swedish stockmarket, including global giants such as Ericsson. The Agnelli family controls 10.4% of the Italian stockmarket. In Hong Kong the top 15 families control assets worth 84% of GDP, in Malaysia 76%, in Singapore 48% and in the Philippines 47%.The majority of the world’s most successful medium-sized companies are also family firms. Hermann Simon, chairman of Simon-Kucher & Partners, a consultancy, calculates that they account for two-thirds of Germany’s mighty Mittelstand, including world leaders in doors (Dorma), balancing machines (Schenck) and industrial mixers (Ekato). Italy has a large number of family-owned global champions in taste-conscious niches: Ferrari in cars, Versace in fashion, Ferrero Rocher in chocolates.

Family companies’ sense of ownership gets round two of the most troubling defects of modern capitalism: short-termism and the so-called agency problema

The most striking thing about family companies is arguably not their average quality but their variance: they have more than their share of pariahs as well as paragons. Portugal’s Espírito Santo was one such pariah: massive debts turned the family-owned financial conglomerate into one of Europe’s largest corporate failures, obliging the government to save the family from the consequences of its own greed and folly.The best thing about family companies is their sense of ownership. That helps them get round two of the most troubling defects of modern capitalism: the focus on short-term results and the so-called agency problem (the potential conflict of interest between owners and managers). On their own admission the CEOs of public companies find it hard to think about the long term because they have to focus on “hitting the numbers” every quarter, and the length of their job tenure has fallen steeply over the past decade. Family owners regard their shares as long-term investments and keep a close eye on management even if they do not run the company.

Clogs to clogs

The worst thing about family companies is succession. This is difficult in all organisations, but especially so in family firms because it involves the biological as well as the institutional sort and throws in a mass of emotions. Family businesses that restrict their choice of heirs to their children can be left with dunces. Moreover, wealth corrupts, a principle so well-established that many languages have a phrase for it. In English it is “clogs to clogs in three generations”; in Italian “from stables to stars to stables”; in Japanese “the third generation ruins the house”; and in Chinese “wealth does not survive three generations”. According to the Family Business Institute, an American consultancy, only 30% of family businesses survive into the second generation and 12% into the third. A mere 3% make it into the fourth and beyond.More broadly, family businesses often suffer from human quirks. Alfred Sloan, the founder of General Motors, argued that the aim of professional management was to produce “an objective organisation” as distinct from “the type that gets lost in the subjectivity of personalities”. That was much in evidence at his great rival, the Ford Motor Company, where Henry Ford’s idiosyncratic behaviour almost ruined the business. But that “subjectivity of personalities” can also enable family bosses to make brilliant decisions which elude professional managers.This special report will argue that family companies are likely to remain a significant feature of global capitalism for the foreseeable future, thanks to a combination of two factors. Family companies in general are getting better at managing themselves: they are learning how to minimise their weaknesses while capitalising on their strengths. At the same time the centre of the modern economy is shifting to parts of the world—most notably Asia—where family companies remain dominant. McKinsey, a consultancy, calculates that by 2025 an extra 4,000 founder- or family-owned companies could hit sales of $1 billion. If this proves correct, family firms in emerging markets might then make up nearly 40% of the world’s large companies, compared with 15% in 2010. McKinsey’s habit of conflating founder-owned firms and family firms is less problematic in Asia than it is globally because founder-owned firms there are more likely to become true family firms. The consultancy is right, too, about the direction of change: the world’s most dynamic region also happens to be the friendliest to family businesses.To understand family companies better, business analysts will need to pay more attention to their internal dynamics. These firms are not just immature public companies, nor are they just highly successful startups. Some of their distinctive behaviour is explained by their “familyness” in the same way that public companies’ behaviour is explained by their “publicness”. Investors will need to look more closely at things like succession planning and whether family members are getting on well together. Academic theorists reflecting on the reasons why firms exist will need to add one more: their role as a mechanism for the transmission of property to future generations.Since family companies are not just surviving but flourishing, many assumptions about the nature of modernity will have to be rethought. Classical sociologists and classical economists both predicted that family businesses would retreat as societies became more rational and bureaucratic. Families themselves would become nothing more than “havens in a heartless world”, as Christopher Lasch, a historian, put it. But that orthodoxy is crumbling in the face of growing evidence that family dynasties can do well in even the most sophisticated modern societies.

Figuring out how to convert a nest egg into enough income to fund a comfortable retirement without completely draining savings is perhaps the biggest issue facing retirees and financial advisors. Wade Pfau, a soft-spoken, Princeton University-trained economist, has taken on the task of trying to solve the puzzle.

Pfau, 37, spent the first decade of his career teaching economics to bureaucrats from emerging markets at the National Graduate Institute of Policy Studies in Tokyo. But he has long had an interest in retirement, going back to his doctoral thesis, which focused on President George W. Bush’s Social Security reform proposal. Pfau came into the limelight in 2010 with a paper that poked holes in the 4% rule long used in financial planning to help retirees spend a nest egg judiciously. After data showed that the rule, which posits the withdrawal of 4% of a portfolio in the first year of retirement, with annual adjustments for inflation thereafter, had worked in only two of 20 developed countries -- the U.S. and Canada -- Pfau dug deeper. He found that the rule wouldn’t work in a number of circumstances, including retiring during a market downturn and in a period of historically low interest rates.

“If you are spending while your portfolio is declining, you are not going to get the full benefit of a market recovery.” —Wade Pfau Photo: Dave Moser for Barron’s

Pfau is now a professor of retirement income at the American College of Financial Services, in Bryn Mawr, Pa., and teaches financial planning. He also serves as director of retirement research at McLean, Va.–based McLean Asset Management, which oversees $640 million. His most recent research creates a framework to compare some of the variable-withdrawal strategies used by financial advisors, including the 4% rule and variations of it.

He ran simulations on the methods’ models, as presented in Journal of Financial Planning articles, to analyze the type of flexibility they offer and how well they work. We spoke with Pfau about the problems with the 4% rule, potentially better options, and how to adjust investments and spending at the start of retirement.

Barron’s: The 4% rule was first introduced in 1994 by financial advisor Bill Bengen, and quickly became conventional wisdom. What’s wrong with it?

Wade Pfau: Where to begin.…It’s not always appropriate. The rule suggests that if retirees withdraw 4% of their portfolio in their first year of retirement, and adjust that initial amount for inflation in subsequent years, they’ll have a low risk of depleting their portfolio in 30 years. In 1994, a 30-year retirement was a conservative assumption -- retiring at 65 or even 55 and living another 30 years was well beyond average life spans. But today, there is a 50% chance that one member of a higher-income, 65-year-old couple will live until 95.

What else troubles you about the 4% rule?

The rule is based on the worst case in U.S. history [the Great Depression]. But the 20th century was a special case -- the U.S. became the world’s leading superpower. When the stock market declined, it recovered quickly. It took longer to recover during the Depression, but bonds did well enough to save the 4% rule. The rule also depends, in part, on interest rates to generate income; now people have to spend their principal to meet the 4% withdrawal rate. It is also more exposed to sequence-of-returns risk, which amplifies the risk that retirees’ portfolios won’t last through their lives.

What is “sequence-of-returns” risk?

If you suffer a market downturn early in retirement, and you are spending while your portfolio is declining, you are not going to get the full benefit of a market recovery.

How should retirees evaluate the market?

[Robert] Shiller’s P/E ratio [price divided by 10 years of inflation-adjusted earnings] is a good predictor of declines in sustainable spending rates. The stock market’s high P/E combined with low interest rates creates a risky environment for retirees invested heavily in a portfolio of stocks and bonds.

If 4% is the wrong starting point, where should retirees begin?

For inflation-adjusted spending, 3% is a better starting point. If 3% is too low, you can withdraw more if you’re willing to be flexible with spending. Or you can avoid self-managing the risks and include an income annuity to cover basic expenses over the course of your retirement.

Are medical and long-term costs baked into that basic expense number?

No. That’s an extra amount on top of what you need to cover your normal lifestyle expenses. The Employee Benefit Research Institute estimates that a 65-year-old couple should save between $241,000 to $326,000 to cover medical and drug costs. That doesn’t include long-term care.

Trying to fund all health and long-term care expenses from a financial portfolio is probably not the best approach. There are insurance options, but it’s too complicated to sum up quickly. [For more on long-term care insurance, see “Protect Your Future.”]

How do you hedge market risk?

Have a less volatile portfolio, like a 30-year bond ladder, or be flexible with spending. Either can help to reduce the risk of sequence of returns. If you can cut spending after market declines during your retirement, you can spend more initially and still make it work. Another option is reducing volatility when you are most vulnerable -- early in retirement when you have the largest portfolio.

I’ve done work with financial advisor Michael Kitces [who works at Pinnacle Advisory Group and writes extensively on retirement issues] on increasing the allocation to stocks as people get further along in retirement, as a way to manage risk.

That runs counter to the conventional wisdom of reducing your stock holdings as you age.

That may work in pre-retirement but not in retirement. Historically, the worst-case retirement scenarios include poor market returns early on. If you have a higher stock allocation when getting poor market returns and lower it when the market gets better, you end up with a worse outcome. It’s exactly the scenario in which a rising equity allocation over retirement would help.

But if you have more in stocks later in retirement and the market falls, aren’t you in worse shape?

Not if you have a conservative starting withdrawal rate or a variable spending rate. You would still have enough money to fund your retirement.

What is the right stock allocation and how should retirees increase it over time?

The 4% rule research recommends starting with 50% to 75% in stocks. It should be more like 30% to whatever someone is comfortable with -- perhaps 60%. We don’t yet know the optimal amount of increase in stocks, though increasing the allocation to stocks by 2% a year was better than 1%. We didn’t test higher increments.

Your latest research looks at 10 different variable-spending strategies. What were you trying to determine?

Variable-spending strategies are on a continuum between spending a constant amount from the portfolio each year, without regard to the portfolio balance, and spending a fixed percentage of the remaining balance.

But these strategies are difficult to compare because they have different assumptions. Some use a set period of time, like 30 or 45 years, while others used life-expectancy tables. The approaches using a fixed amount of years tended to allow for higher initial spending, and kept the amount retirees could spend relatively steady. The actuarial approaches are steeped more in a “safety first” philosophy and call for more frequent adjustments in spending.

You also analyzed the required minimum-distribution method used by the Internal Revenue Service. How did that fare?

It tends to be too conservative in how much a retiree gets early in their 60s or 70s, but lets them spend a lot of money in their 80s. If they make it into the 90s, there is not much left. That’s not necessarily the path retirees want.

Which method has the most potential?

I’m leaning toward some combination of an income annuity and a method used by [Cornerstone Wealth Advisors’] Jonathan Guyton, whose model I simulated. It’s a complicated set of rules but adjusts spending based on the market, limiting the fluctuations in the withdrawal amount to only 10%, and only when absolutely necessary.

How does it work?

The initial withdrawal rate is between 4.8% and 6%, based on the stock/bond mix. At the end of each year, the retiree takes the preceding year’s withdrawal amount [in dollars] and adjusts it for inflation.

But there are guardrails against big market swings: If that amount divided by the current portfolio balance equals a withdrawal rate of 20% more or less than the initial rate, the retiree adjusts the amount they withdraw that year. No annual withdrawal is more than 10% more or less than the year before.

That flexibility enables them to start with a higher withdrawal than if they were just following the 4% rule.

If you’re not willing to be flexible in how much you withdraw, you should probably stick to a 3% rate.

Why use an annuity along with it?

The income annuity provides protection on the downside. You can invest enough that the annuity payouts will cover your essential spending, and the rest of your portfolio you can invest more aggressively. The annuity effectively replaces the bond allocation for retirees. A lot of traditional wealth managers really hate income annuities, but it’s hard to make a strong argument against them. You also get the added benefit of mortality credits, which is the boost a retiree gets from pooling his mortality risk with others who may not live as long. The case is even stronger for a couple, since the chance of one of the living to 95 is greater.

But with interest rates near historic lows, it doesn’t seem like a great time to lock up money in an income annuity.

Investors could put money into income annuities over time, rather than all at once. Doing so also helps diversify between different companies and stay under the state limits to have that money guaranteed -- the limits vary but are often around $100,000 [per owner, per issuer].

How does asset allocation change the withdrawal equation?

I have created an online retirement tool that gives pre-retirees a target of how much you would want saved to implement a withdrawal strategy. If a couple saved 15% a year for 30 years and put their entire nest egg in a 30-year bond ladder of TIPS [Treasury inflation-protected securities], they would get a higher initial withdrawal rate than investing in a volatile investment portfolio. If you have stocks and bonds, there is more upside but also downside risk.

A bond ladder with a 3.65% withdrawal rate, adjusted for inflation, will give you a 90% likelihood of not running out of money after 30 years. Unlike [with] a traditional bond ladder, the retiree uses the cash flow from each year’s maturing bond, rather than reinvesting it. The problem is what happens if they make it to their 31st year. An immediate annuity would offer a 3.75% rate and cover the couple for life. Both offer a higher initial withdrawal rate than what a stock/bond portfolio would allow for. While there is potential for upside in an investment portfolio, you need to spend less initially to protect against worst-case scenarios in the market.

Why wouldn’t a more conservative investor stick with a bond ladder and call it a day?

For a more conservative individual, that may be a question to really think about -- especially since these calculations only assume fees of 0.5%, which is below the average mutual fund fee. The main drawback of not using stocks is no upside potential. Using the Guyton method, a couple with a 50% stock/50% bond mix could start with an initial withdrawal rate of 5.3% with a 90% chance of not outliving their money.

All this begs the question of how much money you need to retire.

Determine the amount needed for basic expenses not covered by Social Security and pensions. A couple, for example, who need $100,000 from their portfolio every year for expenses and whatever taxes they may incur would need $2.7 million in an inflation-adjusted income annuity with a 3.75% payout ratio. They would need more if they plan to put some of their portfolio in stocks. Health and long-term care expenses require an extra amount on top of the basic-expenses estimate. The same goes for anything you want to leave behind in an estate.

What is the take-away for retirees looking for a quick formula or rule of thumb?

There are no easy answers. People shouldn’t spend more time shopping for their next vacuum cleaner than thinking about how they will manage their retirement income strategy.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.